Junk Bond Spread Drops Below 400 Basis Points

By Michael Aneiro

Now that the Fed has kicked off tapering, if you’re searching for bond-market intrigue as we enter 2014, keep an eye on the average junk-bond risk premium. Also known as spread, this measures the yield difference between a high-yield bond and a Treasury bond of comparable maturity, and it basically tells you how much extra you’re getting paid to take on the credit risk of owning junk-rated debt.

Said spread has now dropped below 400 basis points (4.0 percentage points) to 397 basis points, according to the latest reading on a benchmark Bank of America Merrill Lynch high-yield index. In June 2007, at the peak of the last credit cycle, it bottomed at an all-time low of 240 basis points; during the depths of the financial crisis, it approached two thousand basis points. The historic average is a bit below 500 basis points, and spreads have held reliably above 400 bps for the past half-decade or so, even as junk bond yields set new historic lows in 2012 and 2013.

On the eve of 2014, junk bonds now yield 5.59% on average, and pay you less than 4 percentage points more than comparable Treasuries. Oddly, this could still prove to be adequate compensation for credit risk for the time being, given that credit risk remains secondary to interest-rate risk in the eyes of many investors, and the default rate for junk-rated companies, currently 2.4%, is expected to hold steady through 2014.

Last May, when the average junk bond yield dipped below 5% for the first time ever and the average price hit a record 107 cents on the dollar I spoke with Brad Rogoff, head of credit strategy at Barclays. He said relatively reasonable average spreads – then at 406 basis points, still well off historic lows – were pretty much the only thing that still justified buying junk bonds.

“Usually this is a market that’s traded based on yield, but now it feels like it’s trading based on spread,” Rogoff said then. (The investment-grade corporate bond market typically trades based on spreads.)”It’s much tougher to justify based on historical yield standards but on spread, its reasonable.”

For the past few years (until last May), junk bond yields fell as Treasury yields fell, and spreads followed suit. If average yields start marching lower again in 2014, it’s more likely going to be based on falling spreads alone. If junk bonds remain in favor, investors will need to be diligent about making sure they’re getting paid for credit risk, since it might look tame now but it always rears its head eventually.

Checking on the two big high-yield exchange-traded funds today, the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) is up 11 cents to $92.93, and the SPDR Barclays Capital High Yield Bond ETF (JNK) is up 5 cents at $40.56.

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There are 5 comments

DECEMBER 31, 2013 12:00 P.M.

VARINVEST wrote:

Dear Barron's , the everyday rising stockmarket seems bubbly now,sell your stuff to the fools while they pay you skyhighprices for everything. Way too much bullishness.

DECEMBER 31, 2013 1:33 P.M.

DM wrote:

Relative value is for suckers.

JANUARY 1, 2014 1:23 P.M.

credit trader wrote:

if you are bullish on stocks you cant be bearish credit. spreads will tighten a lot more from here.

JANUARY 2, 2014 10:56 A.M.

Corey wrote:

I've been 100% invested in sub investment grade bonds since about 2008 now. They have done nothing but go up. My values hardly fluctuate, and I've seen YOY growth overall of over 15%. I've only ever had one bond default (company went belly up), and I got most of my money back actually. The thing is, in your article, you are giving way too much credit to the bond rating agencies. They really suck honestly. Even when Bear Sterns was at death's door, they still gave them a AA rating while companies like Valero and HCA are considered junk. What I do is evaluate the companies as a whole and ignore the bond rating. (it almost seems random anyway) If a company is profitable, is in a stable industry, and has a lot of assets, it's a good investment. Also, I stay away from anything financial. They are all way overrated.